Leverage, Rehypothecation & Counterparty Risk: Lessons from Traditional Finance

![](https://i.imgur.com/qajICcX.png) # Leverage, Rehypothecation & Counterparty Risk: Lessons from Traditional Finance Written by Sean McOwen ## Executive Summary Some of the new ideas in decentralized finance are really just reincarnations of the same ideas from equity, fixed income, derivatives and other financial markets. Leverage and counterparty risk were what caused the Lehman Brothers collapse to have such a wide ripple effect to other banks. The highly leveraged Lehman Brothers defaulting led to losses on connected banks, margin calls on other mostly highly leveraged banks, a drying of liquidity within capital markets, and a death spiral of banks trying to cover and unwind all at the same time. This in one way is a contagion effect, but in another way is a feedback loop; banks are forced to sell to cover margin calls and liquidity needs, prices fall as a result, and then more margin calls and selling continues. ## How do this apply to crypto? 1. Avoid re-inventing the wheel in terms of mechanisms - For example: future trading for SP500 could allow investors to get $20 of exposure for $1, 20x leverage... A 5% drop in the index would completely wipe out a position and anything after would mean you actually owe money. There are many regulations and mechanisms in place to make this risk taking possible without crashing brokers that we can learn from. 2. Understand just how risky things like leverage and rehypothecation can be by studying history. This presentation will focus on the following: 1. Core Concepts 2. A Historical Example: Long Term Capital Management 3. Agents participating in these systems 4. Agent risk reduction mechanisms 5. Regulatory tools and their role in risk reduction 6. Further Resources As a note, everything described here is in regards to tools and risks. As such it will not focus on the benefits. There are very important roles that things like leverage can play; it allows us to do something like buy a house without having the full value on hand. They just will not be covered in this. ## Core Concepts ### Counterparty Risk The risk that one takes on from interacting with another person or institution, especially in relation to their ability to pay. Finance Example: AIG, an insurance company, was the insurer for many companies and also held collateral from many companies. They invested this collateral they held heavily in mortgage backed securities and when the MBS market blew up, they all of a sudden could not pay out claims. This is an example of counterparty risk; companies were owed huge sums of money from AIG but AIG went into default. Crypto Example: If a person stakes collateral in service A, and service A uses their collateral for the service, there is counterparty risk that service A may not be able to return their stake at a later point. ### Rehypothecation When one party takes collateral that was given to them and then lends out this collateral. This will be further illustrated in regards to how securities lending works with banks. ### Leverage Leverage is a ratio of either the amount of notional risk or borrowed amount of money + owned money divided by the money an institution or person has in terms of collateral or the company value. Slight variations exist depending on the market but overall it is a measure of how much more money there is in debt or risk versus what the person/firm has in value/cash. Example: Fund A has $100 to invest in the stock market. To increase their returns they borrow $200 from the bank and invest $300 in stocks. These means they have a leverage of $300/$100 = 3. A 10% return on the market means they actually made a 30% gain ($\frac{.10 \cdot 300}{100} = .3$). A 10% loss in the stocks likewise means a 30% loss for the fund. ### Margin Margin is collateral that needs to be put up when taking on risk or debt. ### Derivatives Special contracts that are essentially bets on different asset movements. A call option, for example, has the buyer first pay a premium like let's say $5 to the call seller. This contract specifies a date where it can be used, and a strike price. If the stock price that the contract is based off of is higher than the strike price, the buyer gets paid the difference, otherwise they get nothing (but do not get their money back). This kind of contract leads to possible risks of things like a stock doubling in value, then what happens to the option seller, do they default? The equation of a call option profit for example: $$max(S-X,0)-P$$ where $S = \text{Stock Price}$ $X = \text{Strike Price of Call Option}$ $P = \text{Premium paid}$ ## Historical Example: Long Term Capital Management - Created and run by some of the smartest minds in finance, including a nobel prize winner, this fund used mathematical models to earn huge returns primarily on arbitrage events. At first it posted fantastic returns and was well regarded. - LTCM had $125 billion in assets and $4.8 billion in equity. This implies leverage of 26. [^1] - The arbitrage that crashed the fund involved the russian rubel and what is important to note is they were correct on what would happen if they could hold on to their position. - Unexpectedly Russia announced "devaluation of the ruble and declaration of a debt moratorium" which led to a "flight to quality" in which investors avoided risk and sought out liquidity.[^1] - Even though LTCM was correct they had to begin unwinding positions to cover and post more margin leading to government intervention and the closure of the fund. - Key Point: Even though LTCM was overall correct and the risk models predicted it was near impossible to take heavy losses thanks to hedging risk, a black swan event was able to push their risk too far and the high leverage made it impossible to survive long enough until things corrected and they would have been fine. ## Agents ### Banks - General - In general, banks are a great example of how leverage works. When you deposit money into a bank, they are taking that money and putting it to use elsewhere on things like writing loans for houses. - The same applies for businesses; when a business wants to scale their production they will approach banks and get loans to be paid back with interest. - **Fractional-reserve banking**: The system of banking in the modern world where there is a reserve requirement for cash held in banks but the rest can be invested elsewhere leading to a much greater money supply. If the reserve requirement for every dollar is R, it can be shown that every dollar in the bank really reflects the following multiple in supply: $$ \frac{1}{R}$$ ### Banks - Securities Lending - One relevant department within a bank for this discussion is securities lending which is where rehypothecation may happen. The following example represents what happens with rehypothecation: 1. Fund A uses a bank to hold their stocks, let's say they have 100 shares of AAPL at the bank. At any point they can sell those shares and it will be routed out from the bank to the new owner. 2. Without rehypothecation, these shares sit idle at the bank. However, the bank can offer to give a modest yield on the stocks for allowing them to essentially rent the shares out while not in use. Let's assume Fund A consents. 3. The bank had 900 shares of APPL before Fund A, and with these 100 shares they now have 1000 shares. 4. Fund B comes to the bank and asks to borrow 200 shares of AAPL to do a short sale (bet against AAPL). The bank transfers the shares to Fund B and earns a yield from this which will be more than what they give Fund A (they profit from the spread). Now they have 800 shares. 5. Either: 1. Fund B eventually is done with the short position and returns the shares. The bank is back to 1000 shares 2. Fund A moves to sell/transfer shares in which case the bank needs to give 100 shares to them reducing the number of shares they have on hand to 700. - This exchange is good for all parties because Fund B is able to short sell stocks, the bank is able to make money on the spread, and fund A is able to make extra money without doing any work. - This exchange can be dangerous if the bank lends out too many stocks and can't in the near term fulfill their obligations when Fund A looks to sell or transfer shares. ### Derivatives Markets - These markets allow buying and selling of a wide variety of derivatives. - The risk is often that the person on the other side of the trade does not come through on their obligation to pay if the derivative plays in your favor. - There are two types of markets: exchange traded (standardized on an exchange) and OTC (over the counter) which has non standard contracts between parties. - Possible derivatives include those that payoff based on the direction of stock movements, currency swaps that deal with movements in exchange rates between currencies, credit default swaps which are essentially insurance against companies defaulting (one side pays a premium while the other side only pays if the company defaults) and much more. - Purposes include hedging (an airline trying to look in a price of oil is an example), speculation (participants making bets), and arbitrage (making riskless or nearly riskless profit by picking off market inefficiencies) ### Central Counterparty Clearing House (CCP) - Instead of just holding risk against individual counterparties, CCPs create a way to share risk together. - Central counterparty clearing houses (CCPs) perform two primary functions as the intermediary in a transaction: clearing and settlement. As counterparties to the buyers and the sellers, CCPs guarantee the terms of a trade—even if one party defaults on the agreement. CCPs bear the lion's share of the buyers' and sellers' credit risk when clearing and settling market transactions. [^2] - The CCP collects enough money from each buyer and seller to cover potential losses incurred by failing to follow through on an agreement. In such cases, the CCP replaces the trade at the current market price. Monetary requirements are based on each trader’s exposure and open obligations. [^2] ### Banks - Principal Trades - In a principal trade, the executing broker assumes all or part of the risk related to trading the order - The trade is done for a client and as such this increased risk gets priced into the spread ## Agent Risk Reduction ### Loss Mutualisation - By collecting premiums from particpants, CCPs negate the majority of credit risk participants have because when someone defaults, they pay out from the fund to replace the defaulter. - Insurance companies run on the same premise. ### Margin - An initial margin is required when getting into a position - As losses accumulate, there are cutoffs where a margin call happens and the CCP will request a variation margin ![](https://i.imgur.com/YUcirjs.png) [^3] ### Borrow Rate - In securities lending, there some stocks are very plentiful and others which are "hard to borrow" - One reason a stock may be hard to borrow is because so many people are shorting the stock so much of the stock has been loaned out already - Banks deal with "hard to borrow" stocks by charging a higher spread; it costs more in terms of yield to borrow stocks like these. - Some extreme examples are stocks that are so shorted that the rate to borrow can be an annualized 10%. ### Spread - When an executing broker is doing a principal trade, they price in the extra risk by increasing the spread. - The higher the risk, the higher they increase the spread to cover possible losses ### Credit Checks/Scoring - In an attempt to eliminate those most likely to default, banks use credit checks and credit score to quantify how likely someone is to default. - Loan rates can also be adjusted to make up for extra risk different borrowers have. ### Letters of Credit - The LTCM example showcased how in the short term, liquidity can be a huge issue. - Letters of credit are bank pledges that in the case of a need for liquidity, they will provide it to a firm. - These letters of credit can be useful to reduce risk for a firm. In the case where they are temporarily under water, having the ability to call on the letter of credit to get a capital injection can mitigate the risk of default. ### Lock-up Periods - A common technique that hedge funds use is to mandate a lock-up period for withdrawing capital. This period of time is usually something like 3 months after an investor asks to withdraw money from the fund. - The lock-up period allows the fund time to find good pricing on any assets they might need to sell in order to meet the redemption request. - Allows for better liquidity management ## Regulatory Tools ### Basel Accord - The Committee provides recommendations on banking and financial regulations, specifically, concerning capital risk, market risk, and operational risk. The accords ensure that financial institutions have enough capital on account to absorb unexpected losses. [^4] - Minimum ratios of different liquidity/solvency metrics are required and a framework is given which stipulates how all risk must be accounted for as well as what collateral can be used - While tedious for the banks, it provides a way to prevent banks from taking on too much risk that is not backed up by quality collateral ### Fannie Mae/Freddie Mac - Both are government sponsored organizations which produce less risky mortgages for firms to buy the debt of because it is guaranteed by the government - These organizations have quality guidelines to sort out which homeowners are not too extended in buying a home - Because of these guarantees, the market for agency loans (loans coming from these organizations) are much more liquid and carry far less risk ### Federal Reserve Liquidity and Risk Reporting - The federal reserve requires a vast amount of reporting in terms of risk for financial institution so that they can monitor how risk is trending on a macro level - Global systemically important banks have a requirement to have daily reporting on their liquidity positions to allow the Fed to know if an intervention becomes necessary - Stress testing is required yearly which shows potential effects of different possible economic downturn scenarios through risk modeling. ## Additional Resources 1. GSIB Analysis: https://www.bis.org/bcbs/gsib/ 2. The Financial Risk Manager (FRM) certification has a huge amount of resources dedicated to all financial risk. Topics include this information as well as risk modeling and other relevant information. [^1]: https://www.cftc.gov/sites/default/files/tm/tmhedgefundreport.htm [^2]:https://www.investopedia.com/terms/c/ccph.asp [^3]:https://www.researchgate.net/figure/Variation-and-Initial-Margin_fig2_339187920 [^4]:https://www.investopedia.com/terms/b/basel_accord.asp